MIT LIBRARIES D£\NEVll 3 9080 03317 5941 Massachusetts Institute of Technology Department of Economics Working Paper Series THE CRISIS: BASIC MECHANISMS, AND APPROPRIATE POLICIES Olivier Blanchard Working Paper 09-01 December 29, 2008 Room E52-251 50 Memorial Drive Cambridge, MA 021 42 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http://ssrn.con-)/abstract= 1 324280 w The Crisis: Basic Mechanisms, and Appropriate PoHcies* Olivier J. Blanchard^ December 2008 Abstract The purpose of this lecture is to look beyond the complex events that characterize the global financial and economic crisis, identify the basic mechanisms, and infer the policies needed to resolve the current crisis, as well as the policies needed to reduce the probability of similar events in the future. * "Munich lecture'", delivered on November 18, 2008. I thank Stijn Clae.ssens, Giovanni DeH'Ariccia, Giaiuii de Nicolo, Haiiiid Faruqee, Luc Laeven, Krishna Srinivasan, and many others in the IMF Research Department for discussions and help. I thank Ricardo Caballero. Cliarle.? Calomiris, Steve Cecchetti, Pi-ancesco Giavazzi. Anil Kashyap, Arviud Kri.shuanunthy. Andrei Shleifer, and Nancy Zim- merman, for discussions along tlie way. I thank loannis Tokatlidis for research assistance, t MIT. NBKR. and IMF. Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium IVIember Libraries http://www.archive.org/details/crisisbasicmechaOOblan It is much too early to give a definitive assessment of the crisis, not least because it is far from over. It is not too early however to look for the basic mechanisms that have taken us where we are today, and to think about the policies we need to implement, now and later. This is what 1 shall try to do in this lecture. Take it for what it is, a first pass ill the midst of the action.' Figure 1 Iniliat Subprime Losses and Subsequent Declines In World GDP and World Stock Market Capitalization (in Trillions US Dollars) Estimate of Subprime Losses on Loans Estimate of Cumulative World GDP Decline in World Stock Market and Securities by 10/Z0O7 loss Capitalization 9/07 to 10/08 Source IMF Global Financial Stability Report, Wotid Economic Outlook November update and estimates, World Federation ol Exchanges. The best way of motivatiiij; tlic lecture is to start with the chart in Figure 1. The first l^ar (which is barely visible) shows the estimated losses on U.S. subprime loans and securities, estimated as of October 2007. at about $250 billion dollars. The second bar shows the expected 1. Ill the interest of full disclosure: This is a first pass by an economist who, until rccentl.y, thought of financial intermecHation as an i.ssue of relatively little importance for economic fluctuations... cumulative loss in world output associated with the crisis, based on current forecasts. This loss is constructed as the sum, over all coun- tries, of the expected cumulative deviation of output from trend in each coimtry, based on IMF estimates and forecasts of output as of November 2008. for the years 2008 to 2015. Based on these forecasts, the cumulative loss is forecast to run at $4,700 billion dollars, so about 20 times the initial subprime loss. The third bar siiows the decrease in the value of stock markets, measured as the sum, over all mar- kets, of the decrease in stock market capitalization from July 2007 to November 2008. This loss is equal to about $26,400 billion, so about 100 times the initial subprime loss! The question is an obvious one: How could such a relatively limited and localized event (the subprime loan crisis in the United States) have effects of such magnitude on the world economy?' To answer this question, I shall proceed in four steps. First, by identifying the essential initial conditions which have shaped the crisis. I see them as fourfold: the underestimation of risk contained in newly issued assets; the opacity of the derived securities on the balance sheets of financial institutions; the connectedness between financial institutions, both within and across countries; and, finally, the high leverage of the financial system as a whole. Second, by identifying the two amplification mechanisms behind the 2. Ironically, the other shock which dominated the ncw.s until the financial crisis led to the opposite cjuestion: How could the very large increa,se in oil prices from the early 2000s to mid-2008 have such a small apparent impact on economic activity? After all, similar increases are typically blamed for the very deep recessions of the 1970s and early 1980s. The plausible answer, which I shall not explore in this lecture, but is very much worth exploring, must be that the economy has become less fragile in some dimensions, more fragile in others. ' ■ 'i ' ■ ; I. , 1 ; I , , ; ; M 1 ■ crisis, once the trigger had been pulled and some of the assets appeared bad or doubtful. I see two related, but distinct, mechanisms: first, the sale of assets to satisfy liquidity runs by investors; and, second, the sale of assets to reestablish capital ratios. Together with the initial conditions, these mechanisms ca.n lead, and indeed have led, to very large effects of a small trigger on world economic activity. Third, by showing h(}w the amplification mechanisms have played out in real time, moving from subprime to other assets, from institutions to institutions, and from the United States, first to Europe, and then to emerging countries. Fourth, by turning to policies. It is too late to change the initial conditions for this crisis... So, current policies should be aimed at limiting the two amplification mechanisms at work at this juncture. Future regulation and policies should also aim however at avoiding a repeat of some of those initial conditions. In short, we need to both fight current fires and reduce the risk of fires in the future. 1 Initial Conditions The trigger for the crisis was the decline in housing prices for the United States. But, in the years preceding, four evolutions had com- bined to potentially turn such a price decline into a major world crisis. 1. A.s,set.s were created, sold, and bought, which iippenicd much less risky tlinn tlicy truly were. Conditional on no housing price decline, most subprime mortgages appeared relatively riskless: The value of the mortgage might be high relative to the price of the house, but it would slowly decline over time as prices increased. In retrospect, the fallacy of the proposition was in its premise: If and when housing prices actually declined, many mortgages would exceed the value of the house, leading to defaults and foreclosures.^ Why did the people who took these mortgages, and the institutions which held them, so underestimate the true risk? Many explanations have been given, and many potential culprits have been named. To list some of them: Large saving by Chinese households, leading to a low world mterest rate, and thus a "search for yield" by investors disap- pointed with the return on truly safe assets; large private and pul)lic capital inflows into the United States in search of safety, leading sup- pliers to offer what looked like safe assets to satisfy the demand; too expansionary a monetary policy in the United States, with the im- plicit promise of low interest rates for a long time; the "originate and distribute" model of mortgage financing, leading to insufficient mon- itoring by the loan originators. Each of these explanations contains a grain of truth, but only a grain. Why would a low world interest rate necessarily lead to "search for yield"? Why should Alan Greenspan have set a higher US interest rate, if low interest rates reflected low equilil:)iium world rates, and there was no pressure on inflation? Why should investors have bought mortgages from originators if they knew that monitoring was deficient? 3. On the relation between property values, mortgage.s, and foreclosui'es, read Foote et al [2008J I suspect that the fundamental explanation is more general. History teaches us that benign economic environments often lead to credit booms, and to the creation of marginal assets and the issuance of marginal loans. Borrowers and lenders look at recent historical dis- tributions of returns, and become more optimistic, indeed too opti- mistic about future returns.'' The environment was indeed benign in the 2000s in most of the world, with sustained growth and low interest rates. And, looking in particular at US housing prices, both borrowers and lenders could point to the fact that housing prices had increased every year since 1991. and had done so even during the recession of 2001.^ Nor was this understatement of risk confined to subprime loans. Credit default swaps (CDS), which sound complex but are in effect insurance policies, were issued against many risks. For low premia, firms and institutions could insure themselves against specific risks, be it the risk of default by a firm, by a financial institution, or by a country. And CDS issuers were happy to accept these low premia, as they assumed the probability of having to pay out was nearly negligible. 2. Securitization led to complex and hard to value assets on the bal- ance sheets of financial institutions. Securitization had started nuich eaxliei', but changed scale in the last decade. In mid-2008, more than 60% of all U.S. mortgages were se- curitized. In the mortgage market, mortgages were pooled to form 4. For an analysis of credit. Ijoonis and hnsts over a large number of countries, .see Claessens et al [2008]. 5. A point that Charles Calorniris [2(J08] has called "plausihie deniahilit\-" (that prices would ever go down). mortgage-basod securities (MBS), and the income streams from these securities were separated ("tranched") further to offer more or less risky flows to investors. Figure 2, taken from the 2007 IMF GlolDal Financial Stability Report (GFSR) gives a sense of the complexity of that part of the finan- cial system. It shows how initial mortgages were securitized, cut in tranches, and then held by various investors and financial institutions, with different degrees of risk aversion. Going through the various ar- rows would take the rest of the lecture.'' My intent is simply to give a visual impression of the complexity of the financing arra.ngements. Figure 2. Mortage Finance Bough! hy more risk- MtkiiiK i^vL^Ul^^ Rou«h hv Uilh ,1 icr h..,.- seeking ioMMiirs r ■— " ABrprondiiil.s /SIVshuyABS and issue shori- lurm dehi i SubpniiiL- 1" /(■;. Ji-rt Sul>|)riiiH' Suhprijiw Servicer Slit) pri lilt l*ndcr BuiJu /irin-tJr i rtttil linr.iiatiiinluiis/SIVs ; * .Vrriu^.-O-'i"" "l*"*^'- //-.,. jJ: ,!.,.. Sll-U.IUK t i f,n..r,nnM'-lIl '' liisuren. AHS.lfvt»llJ.'lll hy CTM^S .11^ ir.iiichv'd iiuf .■.inicnirvJ If SIV' 1/1 lpi> ^\^ equii. r niKhihyli'-s sk^s^H-'kioL nviisiiirs s nK)s livi.ssuiiigdt^lii Hinj^Jii b risk -SI illVLS ■kiiiu Source. Adapted from Figure 1.10: Mortgage Market Flows and Risk Exposures'' Chapter I, p. 11, October 2007 GFSR. 6. On this, see Gary Gortcni [2007] Why did securitization take off in such a way? Because it was, and still is, a major improvement in risk allocation and a fundamentally healthy development. Indeed, looking across countries before the cri- sis, many (including me) concluded that the U.S. economy would resist a decrease in housing prices better tlian most economies: The shock would be absorbed by a large set of investors, rather than just by a few fina,ncial institutions, and thus be much easier to absorb... This arginnent. ignored two aspects which turned out to be important. The first waij that, with complexity, came opacity. While it was possible to assess the value of simple mortgage pools (the MBS), it was harder to assess the value of the derived tranched securities (the CDOs), and even harder to assess the value of the derived securities resulting from tranches of derived securities (the CDO^s). Thus, worries about the original mortgages translated into large uncertainty about the values of the derived securities. And, in that environment, the fact that the securities were held by a large set of financial institutions implied that this large uncertainty affected a large number of balance sheets in the economy. 3. Securitization and globalization led to increasing connectedness be- tween financial institutions, both within and across countries. In the same way securitization increased connectedness across finan- cial institutions, globalization increased connectedness of financial in- stitutions across countries. One of the early stcnies uf the crisis was the surprisingly large exposure of some regional German banks to U.S. suliprime loans. But the reality goes far l)eyoiul tins anecdote. Fig- ure .3 shows the steady increase m foreign claims by banks from the major five advanced countries, an increase from $6.3 trillion in 2000 to $22 trillion by June 2008. In mid-2008, claims by these banks just on emerging market countries exceeded $4 trillion. Think of what this implies if, for any reason, those banks decided to cut on their foreign exposure; unfortunately, this is indeed what we are seeing now (the figure stops in June 2008. Much of the decrease has happened since then.) • Figure 3 ConsoMcfatad Foreign Claims ol Reporting Banks on the Rest ol the World ey Naiionalllv ot Reporting Banks. Trillions oT US doQars v the IMF, which shows the evohition of heat indexes for a number of asset classes. The construction of the index is complex, but the principle is simple: The larger the decrease in the price of the asset, or the higher the volatility of the price, each relative to its average value in the past, the higher the value of the index. As the heat index increases, the color goes from green to yellow to orange and to red (corresponding to 1, 2, 3 and 4 standard deviations respectively, so orange and red should be seen as very rare events). The figure tells the history of the crisis. Starting from the bottom, see how the crisis started with subprime mortgages in early 2007. extended to financial institutions and money markets (the markets where financial institutions borrow and lend to each other) in the summer of 2007, to regular mortgage pools (Prime RMBS) and cor- porate credit at the end of 2007, and to emerging market countries in the fall of 2008. At the time of this writing, all classes are in red, showing an exceptional decrease in prices and increase in volatility. 2. Increase in counterparty risk. Figure 5 shows how the crisis led to an increase in counterparty risk between banks, i.e. to an increase in the perceived probability that a bank borrowing from another bank may not be able to repay. It plots the "Ted spread" , which is the difference between the average rate charged by banks to each other for ,3-month loans (the "Libor" 3-month rate), and the three-month T-bill rate, the rate at which the government can borrow, for four different countries. Note how the spreads increased from the middle of 2007 on, especially in the United States and the United Kingdom, and how they jumped when the U.S. 15 ,';;■;■,(■ Figure 4. Heat Map: Developments in Systemic Asset Classes Emerging markets Corporate credit Prime RMBS Commercial IVIBS Money markets Financial institutions Subprime RMBS ' "^% Jan-07 Jul-07 Jan-08 Oct-08 ! IMF, Global Financial Stabilily Reporl. Oclobei 200B government let Lehman Brothers to file for bankruptcy in September 2008. Until then, financial markets had assumed that the government would not let large, systemic, banks fail. The failure of Lehman Brothers, and the fact that claims on Lehman became frozen for a long time, convinced them otherwise, lea.ding to a very large jump in the spread. (Note the partial decline at the very end. I shall return to it later.) Associated with this large increase in perceived counterparty risk, was a sharp decrease in the maturity of the loans that banks were willing to make to each other. The result was the attempt, by each bank, to keep enough cash on hand and linrit its reliance^ on borrowing from other banks. 16 Figure 5. Counterparty Risk. 5.0 4.0 3.0 2.0 1.0 - Ted Spreads: 3-month Libor Rate minus T-bill Rate (in percent) 0.0 Sep 15. 2008 Lehman Files lor Bankruptcy j P '■' 1; us Euro Japan UK 3. Tightening banking standards One of the wa,ys a, financial crisis affects the economy is through credit rationing, i.e. the tightening of lending standards by banks who are deleveraging. This is indeed what has happened. Figure 6 shows the evolution of an index for changes in bank lending standards in the United States and the Euro Area, for both mortgage loans and for commercial and inthistrial loans. The index, wliich is based on a cjuarterly survey of bank loan officers, reflects the differ- ence between the balance of respondents between those wlio sa.y they have "tightened considerably-tightened somewhat" and those who say they have "eased somewhat-eased considerably" . The figure shows how, since mid 2008, credit has become steadily tighter for firms and households. 17 Figure 6. Bank Lending Standards ^^ ^;^ ,t> V^ \^i J-' Vt> ,<^' .-^ fl ivl \^ ^J It^- f"- V -o^ r^^ ,^- V "o^ fV 'l* -^^ 'o' ^,' .-.^ V ^ *^ ■ U.S.: C&l loans - U.S.: Mortgages ECB Large company loans ECB Mongages 4. Emerging market spreads and sudden stops Deleveraging has not been limited to domestic credit. For a long time after the start of the financial crisis, it looked as if emerging markets might be shielded from the crisis. The premium most emerging market country governments had to pay relative to the US government (the "sovereign spread") was small, and did not increase much. As Figure 7 shows however, things changed dramatically in the fall of 2008. In the process of deleveraging, advanced country banks started drasti- cally reducing their exposiu'e to emerging markets, closing credit lines and repatriating funds. Other investors did the same. The selling was across the board, but not totally indiscriminate: The figure shows tha.t the premium jumped up substantially more for countries with large current account deficits. Deleveraging in the form of capital outflows presents additional macro- economic problems. Not only do countries have to deal with a domestic 18 Figure 7. Sovereign CDS Spreads (index 7/2/07 = 100) 9.'2'07 1l'2'07 Curreni account deticil larger than 5% of 2007 GDP Current account surplus, or small delicil credit problem (as banks experience a run, and the mechanisms we saw earlier are at work), but they have to deal witli pressure on the exchange rate. If they have reserves, or if they have access to for- eign credit, for example credit from central banks or loans from the IMF, they can use them to limit the depreciation. Otherwise, they may have to accept a large depreciation which, if domestic liabilities are denominated in foreign currency (which they often are) leads to further burdens on debtors, be they households, firms, or financial in- stitutions. The mechanism is familiar from past crises, especially the Asian crisis, and can lead to major economic disruptions. It is playing out in a number of countries today. 5. From the financial crisis to a full-Hedged economic crisis For some time after the start of the financial crisis, the effects of the financial crisis on real activity appeared limittd. This however did 19 not last. Lower housing prices, lower stock prices, triggered initially by the decreased stock market value of financial institutions, higher risk premia, and credit rationing, started taking their toll in the second half of 2007. In the fall of 2008 however, the effect suddenly became much uicnt' pronounced. The worry that the financial crisis was becoming worse, and might lead to another Great Depression, led to a dramatic decrease in stock markets, and to a dramatic fall in consmrier and firm confidence around the world. Figure 8a. Stock Prices ■ EqurnltartnisrAdvincHjEccnwifc! "^fe 6*= -J B^ ^.1^ * ■ .^ ." i' .^ yt v*" _» _*■' . ' j" p," -" .>■ i* v" ■/ v'*^* ti^^-i^Q*- ■> <,«*«,«? v" -^^ ■/ -;** v'" ** ^ iiiuice BloumtiBig and IMH slall o^Iiioal^s. :'i "'^ I - Witt— LATHocnffA - ^5TFn^ElBo'=:' Figure 8a shows the evolution of stock price indexes from markets both in advanced economies and in emerging market countri(\s: After a long and steatiy increase from 2002 on. stock prices started declining m the second half of 2007, and then fell abruptly in the fall of 2008. Figiu"e 8b shows the evolution of business confidence and consumer confidence. It shows the dramatic fall in both intlexes, for the United States, the euro area, and emerging economies, in the fall of 2008. These evolutions have led in turn to a large decrease in demand and in 20 Figure 8b. Business and Consumer Confidence - - Unlwa St»rt» ■ EmBrglna^conomloi I ;A ./^^^^^- EU (right scale) U.S. (Inn acaln) output. Figure 9 shows the IMF growth forecasts as of mid-November. Most advanced countries now have negative growth, and the forecasts are for negative growth in 2009 (year on year) as well. Emerging mar- ket countries are forecast to have positive growtli, but much lower than they have had in the past. The world is clearly now facing a major economic crisis. Figure 9. Real and Potential GDP Forecasted Growth Rates for 2009; in percent -0.4 -0.2 52 hi Euro Area Japan S Real GDP @ Potential GDP Emerging & Developing Economies 21 , '■': ' I- ''•! 4 Policies for the short run It is clearly too late to change the initial conditions which led to the crisis... Thus, in thinking about policies for the short run, the purpose must be to dampen the two amplification mechanisms. 1. Dampening the runs. The way to limit runs is conceptually straight- forward: It is for the central bank to provide liquidity against good (enough) collateral. If they have access to such funds, financial in- stitutions do not need to sell assets at fire sale prices, and the first amplification mechanism does not operate. This is exactly what central banks have done, acting as "lenders of last resort" since the beginning of the crisis. Traditionally, such liquidity provision was limited to banks, and the list of assets which could be used as collateral was relatively narrow. VVliat central banks have done during this crisis is to steadily increase both the set of institutions and the list of assets that qualify as collateral. Since mid-2008, the U.S. Federal Reserve, in particular, has pursued a particularly aggressive liquidity policy. As a result, the monetary base has increased from $841 billion in August 2008 to $1,433 trillion in November, an increase of $592 billion in four months... Has this provision of Ht|ui(lity been successful? The answer appears largely yes, at least with respect to domestic institutions. However, for countries suffering from capital outflows — largely, but not only emerging market countries — things have been tougher. A few countries have had access to credit in foreign currency from the major central banks, in the form of swap lines. But the others have been exposed. Iceland, which had a very large banking system relative to its economy, 22 with assets aiifl liiil)ilili(\s la,rf);(>ly (IcMioiiiiiiat-cd in ciiios, i;)eca,iiic one of \hv first major casualtic's ol' I he crisis. I<"a.('(!cl witli runs (in tliis cfise, the inabihty to borrow in money markets) and not Ix'inf; |)a.rt of the Evuo and thus not, lia.viufi, access to the iiquidil y provided hy the European Central Bank, the tliree major Icela.nihc l)a,nks weul, bankrupt, creating a deep economic crisis ior the country as a whole. Few counlries ar(> as exposed as Iceland was. Mut many are likely to face similar inns, and may need (|Mick a.c;c:ess to ibreign iitiuidity. 2. Asset j)nrchiisrs and ix'c:ij)ilnli'/.ii1i(iii. 'The provision of li(|iiidity eliminates the first amplification m(>clianisni. it does not however ad- dress the scH'ond, namely the icestablishment of capital rat.icjs. Based on the evidence iiom the resolul ion of a large nnmbei- of banking crises in a large number oi' count, lies in the past, what, needs to be done is fairly well established, and has two components: First, tlie state must, isolate bad or potentially bad ass(>ts. 'i'heic are various ajjproaches to doing this. One is lo leave tlie a,ssets on the balcUiee sheet, of the institutions, but have the state provide a floor to theii' value, m exchange for (^xa)nple h)i' slifUcs in the institution. Another, whit;h 1 lintl nujre attra.ctive, is for tiie state to take the assets off the balance sheet altogether, by buying them in exchange for cash, or for' safe assets such as goveiiirnent. bonds. The ccutra.l {|uest.ion is that of the price at which to i)uy t licm. One can think of two extreme prices: the (pre-intcivention) market piice. which may well be a, hre sale |)ric(> a.nd thus embody a large hcinidily discount : or I h(> I'st imated exiXHicd |)resenl value known as the "iiold to maturity" price. The right solution is lo set, I he pi ice belwceii these two exi lemcs. giving, on I he one hand, inst i tut ions incent ivcs to sell and. on the ot hci' hand. 23 taxpayers a reasonable expectation that, if the assets are indeed held to maturity by the state, they will actually benefit from the purchase in the long run. The effect of such asset purchases is twofold. First, it sets the value of the assets on the balance sheets, and by reducing uncertainty, allows investors to better assess the risk of insolvency. Second, it increases the price of these assets from their fire sale price to something closer to their mulerlying expected value, and thus improves the balance sheets of all the institutions which hold these assets, directly or indirectly. These purchases are however half of what needs to be done. Once the value of the assets is clearer, some institutions may turn out to be insolvent, and thus should be closed. Most are likely to show positive, but too low, capitalization and thus must be recapitalized. This can be done through public funds only or through matching of public and private funds, in exchange for shares. The purpose is to return these institutions to a level of capital so they do not need to further deleverage, to further sell assets or cut credit. Where are we today on these two fronts? For some time, governments saw the crisis as one of liquidity, thus a prol)lem to be handled by the central banks through liquidity provision. In the fall of 2008. it became clear that undercapitalization was a major issue. In October 2008, the United States introduced the "troubled asset relief program" (TARP), allowing the Treasury to buy assets or inject capital up to $700 billion. A few weeks later, during an important week end in October, with meetings both in Washington and in Paris, major countries agreed to put in place financial programs along the lines sketched above. Since then, France has committed to spend up to 40 billion euros, Germany 24 Figure 10. 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 O.O Ted Spreads: 3-month Libor Rate minus T-bill Rate - / \ ^-.J^'- ^ — -._.-'' '^ ' "" - -- .__ — -^ ^ — _ ^ , . , 8/1 8/16 8/31 9/15 9/30 1 0/1 5 1 0/30 US Euro Japan UK | up to 80 hilliuii eiuDS, the United Kingdom, 50 billicjii pcjunds. In addition, to alleviate worries about solveney before the programs are fully implenrented, most govenmients have extended the guarantees accorded to depositors to interbank claims, that is claims of banks on other banks. The size and the complexity of the required programs is enormous, and many governments are still exploring their way. In the United States in particular, the TARP appears to have changed direction twice, with an initial focus on the purchase of troubled assets through auctions, then a shift in focus to recapitalization, and in the more recent past, (for example in the case of Citigroup) a reliance on both providing a floor on the value of some of the assets on the balance sheet, and recapitalization. Other programs appear more consistent, but the funds are being disbursed slowly. 25 Are these programs working? The vtndict is mixed. As Figure 10 shows, the spread between the interbaul'C lending rate and the T-bill rate has decreased, but remains surprisingly high, despite interbank guarantees, and despite recapitalization of some banks. Little has been done to dispose of bad assets, and public capital injections have been limited. Uncertainty about the course and the details of policy has made private investors hesitant to invest funds without knowing the nature of future public interventions. The result is that deleveraging continues, with banks continuing to reduce credit, both domestic and abroad. Issues of coordination are also at work. The provision of guarantees for some assets can lead investors to move into those assets, mak- ing things worse for non-guaranteed assets. We have seen this in the United States for non-guaranteed mortgages. The provision of guar- antees by one country can lead investors to move to that country, making things worse for other countries; this was the case for exam- ple when Ireland unilaterally offered guarantees to investors in the fall of 2008. Putting capital controls in one country to slowdown capital outflows can lead to the perception that other countries will do the same, therefore triggering capital outflows in those countries. Pro- tecting domestic depositors and investors at the expense of foreign depositors and investors can create the risk of major outflows from depositors and investors in similar situations elsewhere, and the risk of similar measures by other countries. The attempt by Iceland to do just that led the United Kingdom to invoke an anti-terrorist law to get Iceland to change its mind. Finally, guarantees and other measures taken in advanced countries make it more attractive for investors to put their funds in those countries, and thus can lead to further capi- 26 Figure 11. Sovereign CDS Spreads 3000 (Index 7'2;07=100) i 2500 \ 2000 i r 1500 A 1000 500 0 y / i \ \ \ 9(2/07 11/2/07 1,'2/OS 3/2/08 5/2/08 7/2/08 9/2/08 - - Current account deficit larger than 5% of 2007 GDP Current account surplus, or small deficit tal outflows from emerging market countries. As Figure 11 shows, the sovereign spreads on emerging countries have decreased from their October height, but they remain very high. I have focused on the measures needed on the financial side. The sharp fall in demand and in output in the past couple of months also requires measures to increase demand. Interest rates on government bonds are already very low, so the scope for using traditional monetary policy is limited. The focus must be now on other policies. On the mone- tary side, "quantitative easing", that is the purchase of other assets than government Ijonds by the central bank, can reduce spreads in dysfunctional credit markets. It is clear however that fiscal policy has to play a central role here. At the time of this writing, most countries 27 are developing fiscal packages, intended at increasing demand directly and decreasing the perceived risk of another "Great Depression" . The IMF has argued for a 2% global fiscal expansion, with a commitment to do more if the macroeconomic situation becomes worse than cur- rent forecasts. Sustaining world demand is likely to be a central issue in the next few months. 5 Policies to avoid a repeat Looking forward beyond the crisis (something difficult to do these days), the question arises of how we can avoid a repeat of the same scenario, how we can decrease the fragility of the financial system, without impeding too much its efficiency. Much work is already going on, both in international institutions and in academic departments, ranging from the examination of rules gov- erning ratings agencies, to constraints on executive compensation, to rules for valuing assets on balance sheets, to the construction of reg- ulatory capital ratios, and so on. I have neither the expertise, nor the time here, to go into details. But I can try to give you a sense of the broad directions. Recall the basic argument of this lecture, that the scope of the crisis is due to the interaction between initial conditions and amplification mechanisms. We have already discussed how liquidity provision and state intervention can dampen the amplification mechanisms. The re- maining question, in our context, becomes: Should we try to avoid recreating some of the initial conditions which led to the crisis? 28 ■'';>■ Some of these initial conditions are clearly here to stay. Securitization, and, by implication, relatively complex derivative securities, allow for a much better allocation of risk. The challenge is to prevent complex- ity from turning into opa.city; we can probably do much better than we have in the past. Or, to take another initial condition, cross border activities and large cross border positions are also essential to compe- tition and the allocation of funds and risk in the world. They should not and will not go away. Where something can and probably should be done is in decreasing leverage. Leverage of the financial system as a whole was almost surely too high before the crisis. Regulation can force lower leverage. This requires however increasing the perimeter of regulation beyond banks to many other financial institutions. The challenge here is how and where to draw the perimeter, whether, for example, to put hedge funds in or out, and, if they are in, what rules to put them under. One must also go beyond leverage within the financial system, and look at leverage for the economy as a whole; Highly levered firms or households are also highly exposed to small fluctuations in the value of their assets. The irony is that many existing tax rules favor such leverage, from the tax deductability of mortgage interest payments by households, to the tax deductability of interest payments l)y firms. We have to revisit these rules. Even if and when new regulati(;n is introduced and tax laws are changed, we should be under no illusion that systemic risk will be fully under control. Regulation will be imperfect at best, and always lag behind financial innovation. There will still benign times, and they will lead to underestimation of risk (the first of the initial conditions I 29 listed at the beginning of the lecture). Thus, a major task of regulators will be to monitor, and, if needed, to react to increases in systemic risk. In doing so, they will face two sets of challenges: The first is about monitoring itself, what information to collect, and how to use it to construct measures of systemic risk, both at the na- tional and international level. Some of the information needed is just not available today. We do not know, for example, the distribution of CDS positions among investors and countries. This is one of the rea- sons why many advocate moving trading from over the counter to a centralized exchange; this would allow, in particular, foi' better collec- tion of information. And, even if the information becomes available, how to construct measures of systemic risk is a difficult conceptual exercise. We are surely not there yet. The second challenge is how to react when measures of systemic risk increase. Pro-cyclical capital ratios, in which capital ratios increase either in response to activity or to some index of systemic risk, sound like an attractive automatic stabilizer. They can dampen the build up of risk on the way up, and the amplification mechanisms on the way down. The challenge is clearly in the details of the design, the choice of an index, the degree of procyclicality. Another avenue is to use monetary policy more actively. The idea that monetary policy should be used to fight asset price or credit booms is an old and controversial idea. Before the crisis, some consensus had developed that monetary policy was a very pool tool to fight asset price booms, and it should care only about asset prices to the extent that such prices had effects on current or prospective inflation. The crisis has certainly reopened the debate. 30 6 Conclusions Let me end where I started. This lecture is written in the middle of the crisis. And, as I write it. the crisis appears to be entering yet a new phase, in which a drop in confidence is leading to a drop in demand, and a major recession. This in turn raises a set of new issues, from the dangers arising from the interaction between a deep recession and a weakened financial system, to the risk of deflation and liquidity traps, to further capital outflows from emerging comitries and sudden stops, to an increased risk of trade wars, to the effects of the collapse of commodity prices on low-income countries. I am afraid you will ha.ve to invite me again next year for an update... 31 References (I have made no attempt to give a complete literature review, either in the lecture or in this bibliography. Some of the recent articles listed below trace the ideas to the earlier literature.) Bank of International Settlements, 78th Annual Report, June 2008. Brunnermeier, M., 2009, "Deciphering the 2007-08 Lirjuidity and Credit Crunch" , JEP forthcoming Caballero, R. and A. Krishnamurthy, 2008, "Collective Risk Manage- ment in Flight to Quality" , Journal of Finance, forthcoming Calomiris, C, 2008, "The Subprime Turmoil: What's Old, What's New, and What's Next", working paper, presented at Polak Annual Research Conference. November. Claessens. S. . A. Kose, M, Terrenes, "What Happens during Reces- sions, Crunches, and Busts'.''". IMF working paper. 2008 Diamond, D. and l-". Dybvig, 1983. "Bank Runs, Deposit Insurance, and Liquidity", Journal of Political Economy, 91-5, 401-419 Foote, C, K. Gerardi, L. Goette. P. Willen, "Subprime Facts: What (We Think) We Know about the Subprime Crisis and What We Don't", Public Policy Discussion Papers, Federal Reserve of Boston. Global Financial Stability Report, Fall 2008. IMF Gorton, Gary, 2008, "The Panic of 2007" . working paper Holmstrom, B. and J. Tirole, 1998, "Private and Public Supply of Liciuidit\-". Journal of Political Economy. 1006-1. 1-40 32 Krishnamurthy, Arvind, 2008, "Amplification Mechanisms in Liquid- ity Crises", mimeo Chicago, September Shleifer, A. and R. Vishny, 1997, "The Limits of Arbitrage" , Journal of Finance, 53, 35-55 World Economic Outlook, Fall 2008, IMF. 33